[Federal Register Volume 71, Number 50 (Wednesday, March 15, 2006)]
[Proposed Rules]
[Pages 13306-13316]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-3689]


=======================================================================
-----------------------------------------------------------------------

FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 900, 917, 925, 930, 931 and 934

[No. 2006-03]
RIN 3069-AB30


Excess Stock Restrictions and Retained Earnings Requirements for 
the Federal Home Loan Banks

AGENCY: Federal Housing Finance Board.

[[Page 13307]]


ACTION: Proposed rule.

-----------------------------------------------------------------------

SUMMARY: The Federal Housing Finance Board (Finance Board) is proposing 
to add to its regulations provisions that would limit the amount of 
excess stock that a Federal Home Loan Bank (Bank) can have outstanding 
and that would prescribe a minimum amount of retained earnings for each 
Bank. The proposed amendments also would prohibit a Bank from selling 
excess stock to its members or paying stock dividends, and restrict a 
Bank's ability to pay dividends when its retained earnings are below 
the prescribed minimum.

DATES: The Finance Board will accept written comments on the proposed 
rule on or before July 13, 2006.
    Comments: Submit comments by any of the following methods:
    E-mail: [email protected].
    Fax: 202-408-2580.
    Mail/Hand Delivery: Federal Housing Finance Board, 1625 Eye Street, 
NW., Washington, DC 20006, ATTENTION: Public Comments.
    Federal eRulemaking Portal: http://www.regulations.gov. Follow the 
instructions for submitting comments. If you submit your comment to the 
Federal eRulemaking Portal, please also send it by e-mail to the 
Finance Board at [email protected] to ensure timely receipt by the 
agency.
    Include the following information in the subject line of your 
submission: Federal Housing Finance Board. Proposed Rule: Excess Stock 
Restrictions and Retained Earnings Requirements for the Federal Home 
Loan Banks. RIN Number 3069-AB30. Docket Number 2006-03.
    We will post all public comments we receive without change, 
including any personal information you provide, such as your name and 
address, on the Finance Board Web site at http://www.fhfb.gov/Default.aspx?Page=93&Top=93.

FOR FURTHER INFORMATION CONTACT: Scott L. Smith, Associate Director, 
[email protected] or 202-408-2991; Anthony Cornyn, Senior Advisor to the 
Director, [email protected] or 202-408-2522; Office of Supervision; or 
Thomas E. Joseph, Senior Attorney-Advisor, [email protected] or 202-408-
2512, Office of General Counsel. You can send regular mail to the 
Federal Housing Finance Board, 1625 Eye Street, NW., Washington, DC 
20006.

SUPPLEMENTARY INFORMATION:

I. Statutory and Regulatory Background

    The Federal Home Loan Bank System consists of 12 Banks and the 
Office of Finance (OF). The Banks are instrumentalities of the United 
States organized under the authority of the Federal Home Loan Bank Act 
(Bank Act). 12 U.S.C. 1421 et seq. Although Banks are federally 
chartered institutions, they are privately owned and were created by 
Congress to support the financing of housing and community lending by 
their members (which are principally depository institutions), and as 
such, are commonly categorized as ``government sponsored enterprises'' 
(GSEs). See 12 U.S.C. 1422a(a)(3)(B)(ii), 1424, 1430(i) and 1430(j). As 
GSEs, the Banks are able to borrow in the capital markets at favorable 
rates. They then pass along this funding advantage to their member 
institutions--and ultimately to consumers--by providing secured loans 
known as advances and other financial services to member institutions 
at rates that the members generally could not obtain elsewhere.
    The Banks and OF operate under the supervision of the Finance 
Board. The Finance Board's primary duty is to ensure that the Banks 
operate in a financially safe and sound manner. See 12 U.S.C. 
1422a(a)(3)(A). To the extent consistent with this primary duty, the 
Bank Act also requires the Finance Board to supervise the Banks and 
ensure that they carry out their housing finance mission, remain 
adequately capitalized and are able to raise funds in the capital 
markets. See 12 U.S.C. 1422a(a)(3)(B). To carry out its duties, the 
Finance Board is empowered, among other things, ``to promulgate and 
enforce such regulations and orders as are necessary from time to time 
to carry out the provisions of [the Bank Act].'' 12 U.S.C. 1422b(a)(1).
    Prior to the passage of the Gramm-Leach-Bliley Act \1\ (GLB Act) in 
November 1999, all Banks issued a single class of stock with a par 
value set at $100. Generally, all transactions in this stock were 
required to occur at the par value. See 12 U.S.C. 1426(a) and (b)(3) 
(1994); 12 CFR 925.19 and 925.22(b)(2). By statute, Bank members were 
required to purchase and retain a minimum amount of stock equal to the 
greater of: (i) $500; (ii) 1 percent of the member's aggregate unpaid 
principal balance of home mortgage or similar loans; or (iii) 5 percent 
of a member's outstanding advances. See 12 U.S.C. 1426(b) (1994). 
Further, the Bank Act did not impose specific minimum capital 
requirements on the Banks individually, although the Finance Board did 
establish such requirements by regulation. See 12 CFR 966.3(a).
---------------------------------------------------------------------------

    \1\ Public Law 106-102, 133 Stat. 1338 (November 12, 1999).
---------------------------------------------------------------------------

    The GLB Act amended the Bank Act to create a new capital structure 
for the Bank System and to impose statutory minimum capital 
requirements on the individual Banks. As part of this change, each Bank 
must adopt and implement a capital plan consistent with provisions of 
the GLB Act and Finance Board regulations. Among other things, each 
capital plan establishes stock purchase requirements that set the 
minimum amount of capital stock a Bank's members must purchase as a 
condition of membership and of doing business with the Bank. See 12 
U.S.C. 1426(c)(1); 12 CFR 933.2(a).
    Under the new capital structure, Banks may issue either Class A or 
Class B stock or both. Class A stock is defined as stock redeemable in 
cash and at par six months following submission by a Bank member of 
written notice of its intent to redeem such stock, and Class B stock is 
defined as stock redeemable in cash and at par five years following 
submission of a member's written notice of its intent to do so. See 12 
U.S.C. 1426(a)(4)(A). A Bank must establish in its capital plan the 
classes of stock that it intends to issue, the par value of such stock, 
and other rights associated with this new stock. See 12 U.S.C. 
1426(c)(4); 12 CFR 933.2. Any transactions in Class A or Class B stock, 
whether involving issuance, redemption, repurchase or transfer of such 
stock, must be at par value. See 12 CFR 931.1 and 931.6.
    The GLB Act also requires each Bank to meet certain minimum capital 
requirements once the Bank converts to the new capital structure. Under 
these requirements, a Bank must maintain ``permanent capital'' in an 
amount sufficient to cover the credit risk and market risk to which it 
is subject, with the market risk being based on a stress test 
established by the Finance Board.\2\ By regulation, the Finance Board 
also requires a Bank to hold sufficient permanent capital to meet an 
operations risk charge. See 12 CFR 932.3. See also Final Rule: Capital 
Requirements for the Federal Home Loan Banks, 66 FR 8262, 8299-8300 
(Jan. 30, 2001) (explaining reasons for operations risk capital charge) 
(hereinafter Final Capital Rule). The GLB Act also requires the Banks 
to hold sufficient ``total capital'' to comply with both a ``weighted'' 
and

[[Page 13308]]

``unweighted'' minimum leverage requirement.\3\
---------------------------------------------------------------------------

    \2\ See 12 U.S.C. 1426(a)(3)(A); 12 CFR 932.3. Permanent capital 
is defined by statute to include the amounts paid-in for Class B 
stock plus the retained earnings of the Bank, where retained 
earnings are determined in accordance with generally accepted 
accounting principles (GAAP). See 12 U.S.C. 1426(a)(5)(A).
    \3\ See 12 U.S.C. 1426(a)(2); 12 CFR 932.2. The statute defines 
total capital to include a Bank's permanent capital, plus the 
amounts paid-in by members for Class A stock, any general allowances 
for losses (if consistent with GAAP), and any amounts determined by 
the Finance Board by regulation to be available to absorb losses. 
See 12 U.S.C. 1426(a)(5)(B). The ``weighted'' minimum leverage 
requirement is calculated by multiplying a Bank's permanent capital 
by a factor of 1.5 and adding the other elements of total capital to 
this result, and requires each Bank to maintain a ratio of 
``weighted'' total capital to total assets of at least 5 percent. 
When the leverage ratio is calculated without weighting permanent 
capital, each Bank must maintain a ratio of total capital to total 
assets of at least 4 percent. See 12 U.S.C. 1426(a)(2); 12 CFR 
932.2.
---------------------------------------------------------------------------

    To date, 11 of the 12 Banks have implemented their capital 
structure plans and converted to the new capital structure established 
by the GLB Act. The pre-GLB Act stock purchase and retention 
requirements will continue to apply to the members of the remaining 
Bank until the Bank implements its capital plan and issues its new 
capital stock.\4\
---------------------------------------------------------------------------

    \4\ See 12 U.S.C. 1426(a)(6). The regulatory leverage 
requirement in Sec.  966.3(a) also continues to apply to a Bank 
until it implements its capital plan and complies with the minimum 
capital requirements in the GLB Act. See 12 CFR 931.9(b)(1). The one 
Bank that has not yet converted to the new capital structure, 
however, is operating pursuant to a written agreement with the 
Finance Board, which requires the Bank to hold capital in excess of 
the amount set forth in Sec.  966.3(a). See 2005-SUP-01 (Oct. 18, 
2005). (2005-SUP-01 is available electronically in the Finance 
Board's ``FOIA Reading Room'' under ``Supervisory Actions'': http://www.fhfb.gov/Default.aspx?Page=59&Top=4).
---------------------------------------------------------------------------

II. Proposed Rule Amendments

A. Introduction

    The proposed amendments would restrict the amount of excess stock 
that a Bank can accumulate and keep outstanding and would establish a 
required minimum level of retained earnings for each Bank. These 
changes are being proposed for prudential reasons to address the 
Finance Board's concerns that some Banks increasingly use excess stock 
to capitalize assets that are long term in nature and not readily 
saleable, such as acquired member assets (AMA), or that are not mission 
related, and that the Banks' current levels of retained earnings are 
not adequate to protect against potential impairment of the par value 
of the Banks' capital stock.\5\
---------------------------------------------------------------------------

    \5\ Among other considerations, a Bank's capital stock could be 
deemed impaired if losses have depleted a Bank's current income and 
retained earnings and resulted in ``negative'' retained earnings. 
Capital stock impairment is not necessarily indicative of capital 
insolvency or capital inadequacy. In fact, a Bank could exceed all 
its minimum capital requirements and still have capital stock that 
is impaired.
---------------------------------------------------------------------------

    To enforce these proposed limitations, the amendments are proposing 
to restrict the amount of dividends that a Bank could pay whenever the 
Bank is not in compliance with the minimum retained earnings 
requirements, and to prohibit the Banks from issuing dividends in the 
form of stock. These changes principally would be incorporated into new 
part 934, which the Finance Board is proposing to add to current 
subchapter E of its regulations. Conforming changes are also being 
proposed to other parts of the Finance Board's regulations. The Finance 
Board emphasizes that the proposed excess stock requirements, the 
minimum retained earnings requirements and the related dividend 
limitations would apply to all Banks, whether or not the Bank has 
implemented its capital plan and converted to the new capital structure 
mandated by the GLB Act.

B. Excess Stock Limitation

1. Reasons for Proposing the Excess Stock Limitations
    Excess stock is any Bank capital stock owned by an institution 
greater than the minimum amount that it is required to hold under a 
Bank's capital plan, the Bank Act or Finance Board regulations as a 
condition of becoming a member of, or of obtaining and maintaining 
advances or other transactions with, the Bank.\6\ Generally, excess 
stock may be created in three ways: (1) When stock originally held to 
fulfill a membership or activity-based stock purchase requirement is no 
longer needed because that requirement has decreased; (2) through a 
Bank's payment of dividends in the form of shares of stock rather than 
in cash; and (3) by direct purchase of excess stock by a member.\7\ 
Banks, in their sole discretion, have the right to buy back or 
repurchase a member's excess stock, subject to specific limitations. 
See 12 U.S.C. 1426(e)(1); 12 CFR 925.22(b)(2) and 931.7(b). These 
limitations include a restriction that prevents a Bank from 
repurchasing any excess stock if, after the repurchase, the Bank would 
fail to meet any of its minimum regulatory capital requirements or the 
member would no longer meet any of its stock purchase requirements.
---------------------------------------------------------------------------

    \6\ While Bank stock generally is held only by members of the 
Bank, former members may also continue to hold stock for a limited 
period of time after their membership terminates. A non-member 
institution also may come into possession of Bank stock if it 
acquires a Bank member (whose membership would terminate upon its 
consolidation into the non-member institution), and may continue to 
hold that stock for a limited period of time and for limited 
purposes. Stock held by former members or other institutions also 
may be categorized as either required or excess stock. For example, 
under Finance Board regulations, any indebtedness or other 
transactions that were outstanding at the time an institution's 
membership terminated may be liquidated in an orderly fashion as 
determined by the Bank. Under Finance Board rules, however, Bank 
stock must continue to be held to support such indebtedness or 
transactions during the period of orderly liquidation and until the 
indebtedness or other transactions are paid off or otherwise 
terminated. See 12 CFR 925.29. While these non-member institutions 
may hold Bank stock under limited circumstances, they may not enter 
into any new transactions with the Bank.
    \7\ Finance Board rules currently allow a member to purchase 
excess stock so long as ``such purchase is approved by the member's 
Bank and the laws under which the member operates permit such 
purchase.'' 12 CFR 925.23. As discussed later in the preamble, the 
Finance Board is proposing to amend its rules and to prohibit the 
purchase of excess stock in the future.
---------------------------------------------------------------------------

    Historically, the Banks usually have repurchased excess stock from 
members when requested to do so, although other aspects of the Banks' 
policies on excess stock may differ. In this respect, some Banks 
specifically have limited the amount of excess stock that members can 
hold, or periodically have repurchased excess stock to keep the total 
outstanding amounts of excess stock low. Other Banks do not implement 
such limits or may actively encourage member investment in excess Bank 
stock. Thus, the amount of excess stock outstanding at each Bank has 
tended to vary both in absolute value and as a percentage of the Bank's 
total capital base.
    System-wide, as of December 31, 2005, the Banks had approximately 
$7.4 billion in excess stock outstanding. This equaled about 16 percent 
of the Banks' combined total capital of $46 billion. As a comparison, 
as of December 31, 2005, the Banks collectively had about $36.1 billion 
in required stock outstanding and $2.5 billion in retained earnings. 
These amounts equaled, respectively, approximately 78 percent and 5 
percent of the Bank System's total capital base. For individual Banks, 
the amount of excess stock varied widely at the end of 2005, from zero 
at one Bank to a high of $2.3 billion at another Bank. At the end of 
2005, four Banks had excess stock in amounts that equaled more than one 
percent of their individual total assets.
    Undue reliance on excess stock by a Bank to meet minimum capital 
requirements and to capitalize its balance sheet activities can raise 
both safety and soundness and public policy issues. From a safety and 
soundness perspective, the fact that most Banks have traditionally 
honored in a timely fashion a member's request to have its excess stock 
repurchased could give rise to capital instability, if a Bank were to 
experience large-scale requests to

[[Page 13309]]

repurchase stock in a short period of time. These problems could be 
compounded if a Bank uses excess stock to capitalize investments that 
cannot readily be liquidated, which could create difficulties for a 
Bank to shrink its balance sheet safely and easily to meet these 
repurchase requests.
    A Bank's refusal or inability to repurchase excess stock in a 
timely fashion also could have consequences for members' confidence in 
the Bank System, especially in the long-term, because members have 
viewed Bank excess stock as a fairly liquid investment. It also could 
affect how members' regulators view Bank stock for capital or other 
purposes and thereby affect the value of members' investment in the 
Bank System. To the extent that the members' confidence in the System 
is shaken or they view the value of their investment as declining, 
members could decide to withdraw from a Bank or cease doing business 
with a Bank, thereby undermining a Bank's financial stability.
    The Banks also may use excess stock to generate earnings through 
arbitrage of the capital markets. In this regard, the Banks' GSE status 
permits them to borrow funds at favorable rates that can then be 
invested in money market securities and other non-core mission assets 
to earn arbitrage profits. While this activity benefits the Banks and 
its membership, it does not necessarily further the Bank System's 
public purpose. It can also result in the Banks' being larger and 
holding more debt than otherwise would be necessary if their balance 
sheets were more focused on mission-related activities. Thus, from a 
public policy perspective, this arbitrage activity can have both safety 
and soundness and mission implications.
    Excess stock can play a role in these arbitrage activities by 
providing the Banks a means to capitalize the non-mission investments, 
without necessarily forcing all members to hold more required stock or 
requiring the Bank to build retained earnings. This is especially true 
if a Bank's membership as a whole would be unwilling either to hold 
greater amounts of required stock or to accept lower dividends to build 
retained earnings in order to capitalize these investments. While the 
Finance Board currently limits the amount of mortgage backed securities 
in which a Bank can invest to 300 percent of a Bank's capital, other 
types of non-mission investments are not subject to any limitation.
2. Description of the Proposed Amendments Regarding Excess Stock
    Prohibition on the Sale of Excess Stock. Under the proposed 
amendments, a Bank would be prohibited from selling stock to members, 
or institutions in the process of becoming members, that would be 
excess stock at the time of the sale. To promulgate this change, the 
Finance Board is proposing to revise Sec.  925.23 of its regulations, 
which currently allows members to purchase excess stock if certain 
conditions are met. The Finance Board intends that the proposed 
prohibition on the purchase of excess stock would be interpreted 
narrowly and would only prevent the sale of excess stock by the Banks 
and would not affect how other transactions are treated under Finance 
Board rules.
    Thus, the proposed revisions to Sec.  925.23 would not alter any 
right of a member to continue to hold stock once the stock was no 
longer required as part of a membership or activity based stock 
purchase requirement, albeit such rights would be subject to Bank's 
complying with the limits in the proposed rule, a Bank's discretion to 
repurchase excess stock at any time and to any applicable provisions in 
a Bank's capital plan. Nor would the proposal prevent a member from 
acquiring excess stock in a transfer from another institution as long 
as the transaction was consistent with applicable provisions in the 
Bank Act, Finance Board rules and a Bank's capital plan. The proposal 
also would not affect how stock may be transferred as part of a 
member's consolidation into another institution.
    The Finance Board is also proposing a conforming change to Sec.  
931.2(a) to prohibit a Bank from selling stock to members or 
institutions in the process of becoming a member that would be excess 
stock at the time of the sale. This proposed revision is intended to be 
similar in scope to that proposed for Sec.  925.23 and would affect 
only the sale of excess stock by a Bank and not affect current 
practices or rules with regard to other transactions.
    Overall Excess Stock Limitation and Stock Dividend Prohibition. The 
other major limitations on excess stock are being proposed in new Sec.  
934.1. Under proposed Sec.  934.1(a), the aggregate amount of excess 
stock that could be outstanding at a Bank would be limited to one 
percent of a Bank's total assets. The 1 percent limit would be 
consistent with requiring the Banks to capitalize their mission assets 
with required stock while allowing them to capitalize their mortgage 
backed securities portfolio (limited to no more than 300 percent of a 
Bank's capital) and a liquidity portfolio, equal to what has been the 
historic average of around 10 to 12 percent of total assets, with 
excess stock. In the past, Banks have been able to operate along these 
lines without running into the types of potential difficulties that are 
of concern to the Finance Board and that it believes could arise from 
undue reliance on excess stock.
    Proposed Sec.  934.1(b) would prohibit a Bank from declaring or 
paying a dividend in the form of stock. Stock dividends, along with the 
direct sale of excess stock to members, are the main causes of growth 
in excess stock on the Banks' balance sheets. Thus, the Finance Board 
believes it would be prudent to address the question of whether the 
Banks should be able to issue stock dividends in the future as part of 
this proposed rulemaking. The Finance Board also believes that it would 
be difficult for Banks to issue stock dividends on other than a 
sporadic basis and still comply with the proposed limit on excess 
stock. The Finance Board therefore is proposing to prohibit the 
issuance of stock dividends. The Finance Board specifically requests 
comment on whether the proposed prohibition on the issuance of stock 
dividends is necessary, especially in light of the overall limit on 
outstanding excess stock that is being proposed.
    Non-Compliance with Excess Stock Limit. While the Finance Board 
intends the Banks to maintain compliance with the one percent excess 
stock limit at all times, proposed Sec.  934.1(c) would require a Bank 
specifically to report to the Finance Board whenever the Bank is not in 
compliance with the limit as of the close of the last business day of 
any quarter.\8\ After reporting the violation to the Finance Board, a 
Bank would have 60 days from the end of the quarter in which the 
reported violation occurred to either certify that it is again in 
compliance with the excess stock limitation or develop an a excess 
stock compliance plan, acceptable to the Finance Board, that would 
demonstrate how the Bank would bring itself into compliance with the 
regulatory excess stock limits. The Finance Board believes that a 60 
day period would be adequate for a Bank either to develop a suitable 
compliance plan or to rectify minor or readily-correctable violations 
of the

[[Page 13310]]

limits. Banks that report a violation of the excess stock limitation 
but are already operating under an acceptable excess stock compliance 
plan would, of course, not need to develop a new plan.
---------------------------------------------------------------------------

    \8\ Banks that repeatedly violate the one percent excess stock 
limit during a quarter could be required to develop an excess stock 
compliance plan, if the Finance Board believed the Bank was 
attempting to manipulate excess stock levels to comply with the 
limits as of the last day of the quarter but not as a general matter 
throughout the quarter.
---------------------------------------------------------------------------

    Definitions. The Finance Board is also proposing to make a 
conforming revision to the current definition of ``excess stock'' and 
to move that definition from Sec.  930.1 to Sec.  900.2 of its rules. 
``Excess stock'' currently is defined with reference to the minimum 
investment requirements set forth in a Bank's capital plan. See 12 CFR 
930.1 and 931.3. The definition, therefore, only is applicable to Banks 
that have implemented their capital plans and converted to the new 
capital structure mandated by the GLB Act. The Finance Board intends, 
however, that the proposed excess stock limitations would apply to a 
Bank whether or not it has implemented its capital plan.
    The proposed revision would define excess stock with reference to 
any minimum investment in capital stock required under a Bank's capital 
plan, the Bank Act or Finance Board rules, as applicable. This change 
would allow the definition to apply whether or not a Bank has converted 
to the new capital structure. The proposed revision also would make 
clear that any outstanding stock can be excess stock whether it is held 
by a member, a former member or another institution that may have 
acquired such stock through a merger or consolidation with a member. 
The current definition of excess stock only refers to stock ``held by a 
member.'' Further, under the proposed definition of ``excess stock,'' 
all stock held by an individual institution that exceeds its minimum 
stock purchase requirement would be counted as excess, regardless of 
whether the Bank's capital plan would allow such stock to be ``loaned'' 
or otherwise used to capitalize the activity of other members.
    The Finance Board also proposes to move the definition to Sec.  
900.2 so that the definition would be applicable to all parts of its 
regulations, including the proposed revised Sec.  925.23. Section 
930.1, where the current definition of ``excess stock'' is located, by 
contrast, only applies to terms used in subchapter E.
3. Legal Authority
    The Bank Act provides the Finance Board with broad authority to 
take actions or promulgate regulations as are necessary to supervise 
the Banks and to ensure that they operate in a safe and sound manner 
and carry out their housing finance mission. See 12 U.S.C. 1422a(a)(3) 
and 1422b(a). Given the prudential and mission-related purposes in 
proposing this rule, the Finance Board believes that the proposed 
limitations on the issuance and holding of excess stock are within the 
bounds of these authorities.
    Further, at least with regard to the Class A and Class B stock 
issued under the GLB Act amendments to the Bank Act, the Finance Board 
is specifically authorized to adopt regulations that, among other 
things, permit the Banks ``to issue, with such rights, terms and 
preferences not inconsistent with this [Bank] Act and the regulations 
issued hereunder'' and ``prescribe the manner in which the stock of a 
[Bank] may be sold.'' 12 U.S.C. 1426(a)(4). The proposed prohibitions 
on the sale of excess stock and issuance of stock dividends would fall 
within the scope of this authority.

C. Retained Earnings Requirement and Dividend Limitations

1. Reasons for Proposing the Retained Earnings and Dividend 
Requirements
    A Bank's retained earnings serve a variety of related functions. 
Most significantly, they provide a cushion to absorb losses, help 
prevent capital stock impairment by protecting the par value of Bank 
stock, act as a source of funds to maintain dividend payments in the 
event of temporary shortfalls in Bank earnings, and provide a source of 
capital to fund growth. Given these functions, retained earnings afford 
a margin of protection to both the shareholders and the creditors of a 
Bank.
    The Banks, however, tend to distribute a larger percentage of their 
net income as dividends when compared to other financial institutions, 
and as a consequence have lower levels of retained earnings than other 
financial institutions of comparable size. In part, these lower levels 
of retained earnings may reflect the difficulties that Bank members 
have in realizing tangible pecuniary benefits from higher levels of 
retained earnings given that all transactions in Bank stock occur at 
par value.\9\ Thus, instead of being able to capture the value of 
higher levels of retained earnings in the price at which their stock 
will be redeemed, repurchased or transferred, members must forfeit any 
interest in the retained earnings (above the par value of the stock) 
associated with such shares upon undertaking any of these stock 
transactions.
---------------------------------------------------------------------------

    \9\ See 12 U.S.C. 1426(a)(4); 12 CFR 931.1 and 931.6. The 
history of the Bank System may also play a role in the Banks 
reluctance to build retained earnings. In the late 1980s, the 
Competitive Equality Banking Act of 1987 and the Financial 
Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) 
required the Banks to pay approximately $3.1 billion from their 
retained earnings to capitalize the Financing Corporation (FICO) and 
the Resolution Funding Corporation (REFCORP). See 12 U.S.C. 1441(d) 
and 1441b(e).
---------------------------------------------------------------------------

    While the Banks and members may have incentives to keep the level 
of retained earnings low, a level of retained earnings that is 
insufficient to protect the par value of Bank stock from losses also 
can have serious consequences, if those losses are realized and the par 
value of the stock becomes impaired. In fact, impairment could affect 
the willingness of the members to enter into transactions with the Bank 
as well as trigger regulatory restrictions that can prevent or restrict 
the Bank from paying dividends or from repurchasing or redeeming 
capital stock.
    Whether or not a Bank has converted to the new capital structure 
mandated by the GLB Act, members must purchase new shares of Bank stock 
at par value. See 12 CFR 925.19 and 931.1; 12 U.S.C. 1426(a) (1994). 
Any stock purchased at par value when the par value of the capital 
stock is impaired will result in an immediate economic loss to the 
acquirer. Moreover, if the members were required to record Bank stock 
on their books at its impaired value, any purchase would also result in 
an immediate financial loss to the members. Under these circumstances, 
members could well be reluctant to purchase additional stock needed to 
carry out new transactions with the Bank or to maintain minimum 
membership requirements, negatively affecting demand for Bank products 
and the attractiveness of membership in the Bank System.
    Impairment of the par value of a Bank's capital stock would also 
trigger certain regulatory restrictions on various Bank transactions, 
which could further reduce the value of membership in a Bank. First, 
Finance Board rules allow a Bank's board of directors to declare or pay 
a dividend ``only if such payment will not result in the projected 
impairment of the par value of the capital stock.'' 12 CFR 917.9. This 
provision would prevent payment of dividends during periods of stock 
impairment.\10\ More generally, because a Bank can only pay dividends 
from current net earnings or previously retained earnings a Bank would 
not have a source of funds to pay a dividend whenever it is 
experiencing losses that

[[Page 13311]]

eliminated its retained earnings. See 12 U.S.C. 1436(a).
---------------------------------------------------------------------------

    \10\ As part of this proposed rulemaking, the Finance Board is 
proposing to move the provision prohibiting payment of dividends 
when capital stock is impaired or when such payment would result in 
the projected impairment of Bank stock from Sec.  917.9 to new Sec.  
934.4 of its rules.
---------------------------------------------------------------------------

    Statutory restrictions put in place by the GLB Act would also 
prevent a Bank from redeeming or repurchasing capital stock without the 
written permission of the Finance Board if the Bank has incurred or is 
likely to incur losses that will result in charges against the capital 
of the Bank.\11\ The Finance Board has defined the phrase ``charge 
against capital of the Bank'' to track criteria set forth in the 
Industry Audit Guide published by the American Institute of Certified 
Public Accountants (AICPA) for evaluating impairment of Bank stock. See 
Proposed Rule: Capital Requirements for Federal Home Loan Banks, 66 FR 
41462, 41465-66 (August 8, 2001) (citing AICPA ``Industry Audit 
Guide,'' Sec. Sec.  5.97-5.101 (May 1, 2000)); Final Rule: Capital 
Requirements for Federal Home Loan Banks, 66 FR 54097, 54106 (October 
26, 2001); 12 CFR 930.1.
---------------------------------------------------------------------------

    \11\ See 12 U.S.C. 1426(f). Under the GLB Act provisions, if the 
Finance Board gives permission for repurchases or redemptions while 
capital stock is impaired, such transactions nonetheless would occur 
at the par value of stock. See 12 U.S.C. 1426(a)(4)(A); 12 CFR 
931.7. Allowing for such transaction, thus, would be problematic if 
the impairment were severe.
    The provisions in the Bank Act prior to the GLB Act amendments 
required the repurchase of stock to occur at the impaired value of 
stock rather than at the par value whenever the Finance Board found 
``that the paid-in capital of a * * * Bank [was] or [was] likely to 
be impaired as a result of losses in or depreciation of the assets 
held.'' 12 U.S.C. 1426(e) (1994); 12 U.S.C. 1426(b)(3) (1994).
---------------------------------------------------------------------------

    While harder to predict, an incident of capital stock impairment 
may also result in market reactions that could affect the Bank's cost 
of doing business. For example, impairment of the par value of the 
Bank's capital stock could lead to a downgrade in the credit rating of 
the Bank that, in turn, could raise the rates at which counterparties 
would be willing to enter into hedging transactions with the Bank. 
Further, given that there has not been an incident of capital 
impairment at a Bank, a future incident of impairment could affect the 
costs of funds for the Bank System, at least in the short term, as the 
market attempts to sort out the potential consequences of the event.
    In August 2003, the Finance Board's Office of Supervision undertook 
to get the Banks to address concerns with their relatively low level of 
retained earnings and the Banks' overall approaches to retained 
earnings by issuing Advisory Bulletin 2003-AB-08, Capital Management 
and Retained Earnings (August 18, 2003). The Advisory Bulletin noted 
the Banks' low levels of retained earnings when compared to those held 
by large banks and thrifts. It then called on each Bank, at least 
annually, to assess the adequacy of its retained earnings under a 
variety of economic and financial scenarios. The Advisory Bulletin also 
required each Bank to adopt a retained earnings policy, which was to 
include a target level of retained earnings. Notwithstanding the 
requirements in the Advisory Bulletin, the Finance Board has found that 
there is a general lack of consistency among the Banks' retained 
earnings policies and target retained earnings levels. The Finance 
Board also believes that the retained earnings policies adopted by the 
Banks often lacked clarity and failed to address key risk elements 
cited in the Advisory Bulletin.\12\ Thus, the Finance Board continues 
to have concerns with how the Banks are addressing issues related to 
their retained earnings.
---------------------------------------------------------------------------

    \12\ The Advisory Bulletin stated that:
    * * * each * * * Bank should specifically assess the adequacy of 
its retained earnings in light of alternative possible future 
financial and economic scenarios. The scenarios should include 
optimistic, pessimistic and most likely forecasts. At the minimum, 
the analysis should show the expected change in retained earnings 
that would result from immediate parallel shifts in the yield curve. 
As a matter of sound practice, the analysis should be supplemented 
with non-parallel rate shocks such a flattening and a steepening of 
the yield curve. It would also be useful to analyze scenarios that 
highlight the effect on retained earnings of other key factors, 
including changes in prepayment speeds; changes in interest-rate 
volatility; changes in basis spread between * * * Bank funding costs 
and Treasury rates, mortgage rates and LIBOR; and changes in the 
credit quality of the * * * Bank's investment portfolio.
    Advisory Bulletin 2003-AB-08, at p. 2. This Advisory Bulletin 
can be obtained electronically from the Finance Board's Web site by 
accessing ``Advisory Bulletins'' in the ``FOIA Reading Room'': 
http://www.fhfb.gov/Default.aspx?Page=59&Top=4.
---------------------------------------------------------------------------

    The Finance Board also has concerns because of recent incidents at 
some Banks that raise questions about the adequacy of retained 
earnings. For example, one Bank suffered a credit downgrade of certain 
of its investment securities that were backed by manufactured housing 
loans. As a result, the Bank sold the assets at a loss of nearly $189 
million. After experiencing the loss, the Bank had to suspend the 
payment of dividends for a time to rebuild its retained earnings. Other 
Banks in recent years have experienced steep declines in quarterly 
earnings or recorded actual quarterly losses. Of these Banks, one 
currently has suspended payment of dividends in an effort to manage 
reduced earnings and expected losses over the near term, and two Banks 
have suspended repurchases of stock. Such incidents further underscore 
the need for Banks to hold sufficient retained earnings to protect 
against such events. This is especially true in light of the fact that 
the increase in the Banks' holdings of mortgage assets over the last 
few years has resulted in the Banks' having to manage arguably riskier 
balance sheets than had previously been the case. Changes in accounting 
rules and in the make up of the Banks' balance sheets have also added 
to the potential income volatility that may be experienced by the 
Banks.\13\
---------------------------------------------------------------------------

    \13\ An important accounting change contributing to earnings 
volatility has been the Statement of Financial Accounting Standards 
(FAS) No. 133, Accounting for Derivative Instruments and Hedging 
Activities, which contributes to higher earnings volatility due to 
its asymmetric accounting for different financial instruments. On 
January 25, 2006, the Financial Accounting Standards Board (FASB) 
released an exposure draft, ``The Fair Value Option for Financial 
Assets and Financial Liabilities, Including an Amendment of FASB 
Statement No. 115.'' The changes proposed in the exposure draft 
would allow a Bank to designate certain hedged assets to be carried 
at fair value and thereby eliminate much of the asymmetric 
accounting of derivative instruments and held-to-maturity hedged 
items. The proposed changes would allow entities to re-designate the 
carrying status of existing assets.
---------------------------------------------------------------------------

    To help to ensure that each Bank's level of retained earnings 
adequately reflects its risk profile and that there is greater 
consistency among the Banks' retained earnings policies, the Finance 
Board is proposing a minimum retained earnings requirement. The minimum 
target levels, and the associated proposed restrictions on the Banks' 
ability to pay a dividend when their retained earnings are below their 
minimum targets are intended to encourage the Banks to build retained 
earnings to adequate levels. The Finance Board believes that its 
proposed regulatory changes would reduce the risk that losses could 
deplete a Bank's retained earnings and cause the impairment of the par 
value of a Bank's stock.
    The Finance Board recognizes that capital stock impairment is not 
necessarily indicative of capital inadequacy, and its purpose in 
proposing the rule change is not necessarily to require the Banks to 
increase their overall levels of capital. The Finance Board believes 
that its capital rules and the Banks' overall capital levels remain 
adequate and the risk of capital insolvency at any Bank in the 
foreseeable future is de minimis. The proposed rule, however, does aim 
to change the composition of capital and to ensure that the Banks hold 
retained earnings in amounts that would significantly reduce the risk 
that losses at a Bank would result in capital stock impairment. The 
Finance Board believes that the potential operational and financial 
consequences of capital stock impairment for both the Bank and the 
members justifies addressing the Banks'

[[Page 13312]]

levels of retained earnings as a safety and soundness matter.
2. Description of the Proposed Amendments Regarding Retained Earnings
    Minimum Retained Earnings Requirement. Under proposed Sec.  
934.2(a), each Bank would be required to achieve and maintain a minimum 
level of retained earnings, known as the Retained Earnings Minimum or 
REM. Each Bank would calculate its REM each calendar quarter. The REM 
calculated for a quarter would be used to determine whether the 
dividend restrictions proposed in Sec.  934.3 would apply. For example, 
the REM calculated in the first quarter of the year would determine 
whether any restrictions would apply to the dividend that would be paid 
based on the Bank's first quarter's results. This would be true even 
though under other restrictions being proposed as part of this 
rulemaking, a Bank would not be able to declare or pay its first 
quarter dividend until after the beginning of the second quarter. If, 
after adjusting the retained earnings for any dividend that the Bank 
intends to pay for that quarter, the Bank's retained earnings would be 
below its REM, the Bank must assure that the intended dividend conforms 
to the limitations set forth in proposed Sec.  934.3.\14\
---------------------------------------------------------------------------

    \14\ Thus, to calculate its retained earnings for a quarter for 
purposes of determining compliance with the rule, the Bank would 
subtract from its retained earnings balance as of the close of the 
quarter (i.e, its previous retained earnings plus its current net 
earnings) the amount of the dividend it would like to pay for the 
quarter. The amount of the dividend should include any payments on 
stock subject to FAS No. 150. See n.17. If the resulting amount from 
this calculation is less than the Bank's REM for that quarter, the 
Bank would have to verify that it first complied with all 
limitations proposed in Sec.  934.3 in order to declare and pay its 
intended dividend.
---------------------------------------------------------------------------

    As proposed in Sec.  934.2(b), the REM would equal $50 million plus 
1 percent of a Bank's non-advance assets. Non-advance assets would 
equal the daily average of the Bank's total assets less the daily 
average of its advances, as recorded in the calendar quarter 
immediately preceding the date of the calculation. Thus, a Bank's non-
advance assets for the REM calculation done for the second quarter of a 
year would equal that year's first quarter's daily average of the 
Bank's total assets less the first quarter's daily average of the 
Bank's advances.
    The Finance Board believes that the proposed REM formula would 
provide a straightforward, consistent and predictable means to 
establish minimum retained earnings requirements across the Banks. 
Basing the REM on non-advance assets would provide a broad 
approximation of the potential risks faced by a Bank given that risk of 
losses from advances is very low and the greatest risk of credit or 
market losses would arise from a Bank's non-advance assets.
    A number of provisions of the Bank Act protect the Banks from 
potential credit losses associated with advances.\15\ First, the Bank 
Act requires that a member fully collateralize any advances by specific 
types of high quality collateral. See 12 U.S.C. 1430(a)(3). In 
addition, under the Bank Act, a Bank has a lien on any Bank stock owned 
by its member against any indebtedness of the member, including 
advances, to a Bank.\16\ Thus, should a member default on an advance, 
the Bank has a variety of statutory means to assure that the defaulting 
member absorbs any potential credit losses so that the par value of 
other members' stock would not be affected. Such statutory protections 
are not necessarily applicable to other assets on the Banks' balance 
sheets.
---------------------------------------------------------------------------

    \15\ A Bank has never suffered a credit loss on an advance to a 
member, and the Banks also have a long history of effectively 
managing the interest rate and market risks associated with their 
advances.
    \16\ See 12 U.S.C. 1430(c). Further, under the Bank Act as in 
effect prior to its amendment by the GLB Act or under the capital 
plans of the 11 Banks that have already implemented the new capital 
structure, a member must buy stock to capitalize any advances made 
to it by the Bank.
---------------------------------------------------------------------------

    Moreover, based on the recent credit losses and financial 
difficulties experienced by individual Banks, the Finance Board 
believes that the level of retained earnings required under the 
proposed formula would be sufficient to provide reasonable protection 
against capital impairment while not unduly burdening the Banks. In 
developing a measure for a retained earnings minimum based on the risk 
of the Banks, we explored a number of risk measures, but determined 
that use of the more straightforward approach being proposed simplified 
the application of the proposed requirement and provided a robust 
approximation of the amount of retained earnings needed given potential 
losses faced by a Bank, as calculated under the alternative analysis.
    The alternative analysis relied on two risk measures that are 
commonly available for all Banks, one to represent credit risk and the 
other to represent market risks going forward. First, for credit risk, 
the analysis used the Internal Ratings-Based Approach from the Basel II 
Accord that would apply to large and/or complex financial institutions. 
See Basel Committee on Banking Supervision, International Convergence 
of Capital Measurement and Capital Standards, A Revised Framework, pp. 
48-139 (November 2005); Basel Committee on Banking Supervision, 
Consultative Document, the New Basel Capital Accord, pp. 38-120 (April 
2003). The Basel II methodology assigns a capital charge to credit 
exposures based on the credit rating, maturity and the loss given 
default for the exposure, assuming a credit risk horizon of one year 
and a particular target rating for the institution holding the 
exposure. In applying the Basel II approach to the Banks, the analysis 
assumed a given Bank would maintain a target rating of AA/Aa. This 
approach to measuring credit risk capital is considered state of the 
art for standardized measures. In measuring the credit risk for the 
Banks, this Basel II measure was applied to all credit exposures except 
advances. Advances were excluded because the Banks have never had a 
credit loss associated with an advance to a member institution and 
because of the statutory protections against credit losses on advances 
provided under the Bank Act. See 12 U.S.C. 1430(a), (c) and (e).
    Second, market risks were estimated based on market value of equity 
losses given parallel interest rate shocks of +/-50, 100 and 200 basis 
points. The Banks already provide this information to the Finance 
Board, and currently, these are the only measures of market risk going 
forward that are available for all Banks on a consistent basis. The 
measure of market risk incorporated into the analysis equaled the 
simple average of the worse cases for the up and down shocks.
    Finally, the regression analysis indicated that the sum of these 
credit and market risk measures could be reasonably well approximated 
by $50 million plus 1 percent of non-advance assets. This more 
straightforward formula was deemed more appropriate than using a direct 
measure because it eliminates concerns about model error at the Bank 
level, and is more transparent and easy to monitor and apply over time.
    As proposed, the rule also would provide the Finance Board with the 
flexibility to address specific problems or events at individual Banks 
by requiring a Bank to hold levels of retained earnings that would be 
higher than that calculated under the formula, if warranted for safety 
and soundness reasons. This flexibility would allow the Finance Board 
to refine a Bank's REM if a Bank is more exposed to credit or 
prevailing market risks than would be

[[Page 13313]]

captured by the formula, or if unique operational situations at a 
particular Bank need to be addressed. Addressing these types of issues 
on a case-by-case basis would also avoid having to develop a more 
complicated and complex method for calculating the REM than that being 
proposed.
    The Finance Board also does not believe that the proposed 
requirements would be unduly burdensome for the Banks. In this respect, 
based on estimates of the Banks' earnings and other relevant data, the 
Finance Board believes that if the proposed retained earnings 
requirement had become effective in the fourth quarter of 2005, one 
Bank would have been able to comply with its REM as of December 31, 
2005. Further, the Finance Board estimates that based on a fourth 
quarter 2005 effective date for the proposed retained earnings 
requirement, the other Banks would have been able to meet their REMs in 
line with the following schedule: one Bank in early 2006; another two 
Banks before the end of 2006; five more Banks by the end of 2007; and 
two more Banks by mid 2008. The earnings of the remaining Bank 
currently are unusually low and, given the Bank's current earnings 
outlook, it is difficult to estimate when the Bank would be able to 
meet the proposed requirements.
    Dividend Restriction Based on Non-Compliance with REM. Under the 
proposed rule, if a Bank's retained earnings balance as of the close of 
the quarter and after adjustment for any dividend that the Bank intends 
to pay for that quarter, were less than the Bank's applicable REM, the 
Bank would be subject to the limitations on the payment of dividends 
for that quarter proposed in Sec.  934.3. The proposed rule would allow 
for an initial transition period during which the dividend limitation 
would be less strict than thereafter. The dividend limitation that 
would be in effect during this period is set forth in proposed Sec.  
934.3(a), while the limitation that would become effective thereafter 
is contained in proposed Sec.  934.3(b).
    Under proposed Sec.  934.3(a), a Bank that is not in compliance 
with its REM when the rule first takes effect would be allowed a 
transition period until such time as the Bank first reaches or exceeds 
its REM. During this transition period, a Bank generally would be 
allowed to pay a dividend that did not exceed 50 percent of its current 
net earnings.\17\ The proposed rule would allow a Bank to pay a 
dividend in excess of this 50 percent limit only with the Finance 
Board's prior approval. Among the factors that the Finance Board would 
consider in deciding whether to grant any request under this provision 
would be the size of the gap between the Bank's level of retained 
earnings and its REM, the earnings outlook for the Bank, the Bank's 
risk profile and any recent examination findings related to Bank's risk 
management, corporate governance and other relevant areas that could 
affect the Bank's ability to operate in a financially safe and sound 
manner.
---------------------------------------------------------------------------

    \17\ In determining compliance with this provision, a Bank would 
be expected to include any payments made on its capital stock 
subject to FAS 150 in the total amount of the dividend paid out. 
Under FAS 150, capital stock that is subject to a mandatory 
redemption request would be classified as a liability on the Bank's 
balance sheet and dividend payments made on such stock would be 
classified as an interest expense for accounting purposes.
    As discussed below, the Finance Board also is proposing to add a 
definition for ``current net earnings'' to Sec.  930.1.
---------------------------------------------------------------------------

    After a Bank initially complies with its REM, the dividend 
limitations in proposed Sec.  934.3(b) would require a Bank to receive 
Finance Board permission before declaring or paying any dividend for a 
quarter in which the Bank no longer met its REM. In deciding whether to 
grant such a dividend request, the Finance Board would consider the 
same factors discussed above. Overall, the dividend limitations in 
proposed Sec.  934.3 are intended to encourage the Banks to comply with 
their retained earnings targets while still allowing the Banks the 
flexibility to pay dividends if circumstances warrant. The Finance 
Board specifically invites comment on whether higher percentages for 
the dividend limitations than those being proposed in Sec.  934.3 may 
be appropriate, keeping in mind the Finance Board's goals of 
encouraging the Banks to achieve their REMs in a timely fashion and 
maintain compliance with their REMs thereafter.
    Additional Dividend Limitations. Proposed Sec.  934.4 would set 
forth limitations on the payment of dividends that would apply to a 
Bank whether or not it has met its REM. First, proposed Sec.  934.4(a) 
would prohibit a Bank from declaring or paying a dividend based on 
projected or anticipated earnings and would require a Bank to declare a 
dividend only after its earnings for a particular quarter had been 
calculated. This provision would make clear procedures that already are 
strongly implied given the fact that under the retained earnings 
proposal, a Bank would need to know its retained earnings balance as of 
the close of a quarter to determine whether the proposed dividend 
limitations apply. Thus, a Bank would need to calculate its quarterly 
earnings before its board of directors would be in a position to 
declare a dividend, even in the absence of proposed Sec.  934.4(a).
    Second, proposed Sec.  934.4(b) would incorporate the restriction 
now contained in Sec.  917.9 of the Finance Board's regulations that 
prohibit a Bank from declaring or paying a dividend if the par value of 
the Bank's stock is impaired or would be projected to become impaired 
after paying the dividend. The Finance Board also is proposing to make 
suitable conforming changes to Sec. Sec.  917.9 and 931.4 to reflect 
the limitations on dividends proposed in Part 934.\18\
---------------------------------------------------------------------------

    \18\ The limitations on dividends in proposed Sec.  934.4 would 
be in addition to other dividend limitations set forth in the Bank 
Act and Finance Board rules. See, e.g., 12 U.S.C. 1426(h)(3) and 
1436(a); 12 CFR 917.9 and 931.4.
---------------------------------------------------------------------------

    Definitions. The Finance Board is proposing to add a definition of 
``current net earnings'' in Sec.  930.1. Specifically, ``current net 
earnings'' would be defined as ``the net income of a Bank for a 
calendar quarter calculated in accordance with GAAP after deducting the 
Bank's required contributions for that quarter to the Resolution 
Funding Corporation under sections 21A and 21B of the Act (12 U.S.C. 
1441a and 1441b) and to the Affordable Housing Program under section 
10(j) of the Act (12 U.S.C. 1430(j)) and Sec.  951.2 of this chapter, 
but before declaring any dividend under section 16 of the Act (12 
U.S.C. 1436).'' The Finance Board believes that this proposed 
definition is consistent with the current method for calculating 
earnings for the purpose of paying dividends and, if adopted, would be 
consistent with the statutory restrictions set forth in section 16 of 
the Bank Act with regard to how to determine the Bank's current 
earnings for purposes of paying dividend. See 12 U.S.C. 1436(a). The 
Finance Board also is proposing to add a definition to Sec.  930.1 that 
``Retained Earnings Minimum or REM means the minimum amount of retained 
earnings a Bank is required to hold under Sec.  934.2.''
3. Legal Authority
    The proposed amendments aim to require the Banks to hold retained 
earnings sufficient to protect against the impairment of their capital 
stock. They are in many respects a more comprehensive version of the 
current prohibition in Sec.  917.9, which prohibits dividend payments 
if such payments result in the impairment of capital stock and which 
the Finance Board adopted for safety and soundness reasons in 1999. See 
Interim Final Rule:

[[Page 13314]]

Devolution of Corporate Governance Responsibilities, 64 FR 71275, 71276 
(December 21, 1999); Resolution No. 2000-29 (June 22, 2000). The 
Finance Board believes that the more thorough approach proposed in this 
rulemaking is needed to address concerns that have arisen since Sec.  
917.9 was adopted in light of the change in the risk on the Banks' 
balance sheets and the prospects for more volatile earnings in the 
future.
    As detailed in other parts of the preamble, impairment of a Bank's 
capital stock can present safety and soundness and mission problems 
other than ones related to immediate insolvency of a Bank. The Finance 
Board believes that these concerns provide adequate justification for 
adopting the proposed retained earnings requirement to assure that the 
Banks operate in a safe and sound manner and that they accomplish their 
statutory mission and are able to access the capital markets. Moreover, 
the Bank Act provides the Finance Board with authority to adopt rules 
to address these types of concerns. See 12 U.S.C. 1422a(a)(3) and 
1422b(a)(1).
    The Finance Board also believes that section 16 of the Bank Act 
provides an alternative source of authority to adopt the proposed 
requirement. Specifically, section 16 provides the Finance Board with 
authority to require the Banks to ``establish such additional reserves 
and/or make such charge-offs on account of depreciation or impairment 
of its assets as [it] shall require.'' 12 U.S.C. 1436. The provision 
does not limit the reasons for which the Finance Board can require the 
Banks to establish these additional reserves.
    Section 16 states that the required reserves are to be established 
from net earnings of a Bank and makes a Bank's payment of a dividend 
subject first to funding these reserves. 12 U.S.C. 1436. Historically, 
reserves required under section 16 of the Bank Act were included in 
retained earnings of the Banks, but the use of these reserves to pay 
dividends was restricted. Further, the term ``reserves'' as used in 
section 16 had also been interpreted to exclude loan loss or similar 
type reserves that were recorded elsewhere on the Banks' balance 
sheets.\19\
---------------------------------------------------------------------------

    \19\ See, e.g., OGC Opinion Memo, from K. Heisler to R. Burklin; 
Re: ``Reserves of FHLBanks,'' at p.2 (Dec. 9, 1942) (valuation 
reserves which are held against estimated losses in the value of 
specific assets or similar types of reserves ``are not reserves 
within the meaning of section 16 of the * * * Bank Act). This long-
standing interpretation of section 16 remains consistent with the 
current wording of that provision. Specifically, section 16 states 
in relevant part that Banks may pay dividends out of ``previously 
retained earnings or current net earnings remaining after reductions 
for all reserves * * * required under [section 16].'' This wording 
indicates that section 16 reserves are funded after a Bank 
calculates its current net earnings but before the payment of 
dividends. There would be no need for section 16 to limit payment of 
dividends to ``current net earnings remaining after reductions for 
all reserves * * *'' if the reference to ``reserves'' meant loan 
loss or similar reserves, since provisions for those types of 
reserves would already be considered in the calculation of net 
earnings. 12 U.S.C. 1436(a) (emphasis added). To read the authority 
provided in section 16 to refer to requiring the Banks to hold loan 
loss or similar reserves would violate principles of statutory 
construction which generally require that a statute be read to give 
affect, if possible to every word, clause or sentence. See Norman J. 
Singer, 2A Statutes and Statutory Construction Sec.  46:06 (6th ed. 
2000). The fact that section 16 requires the reserves to be funded 
from net earnings also supports the conclusion that the reserves 
should be part of a Bank's retained earnings. Thus, the most 
reasonable reading of the ``additional reserves'' authority in 
section 16 remains that it allows the Finance Board to require the 
Banks to maintain specific levels of retained earnings.
---------------------------------------------------------------------------

    The requirements in section 16 that the Banks ``establish such 
additional reserves * * * as the [Finance Board] shall require'' and 
pay dividends only ``out of net earnings remaining after all reserves * 
* * required under this [Bank] Act'' have been funded date back to 
original Bank Act in 1932. Public Law 72-304, July 22, 1932, c. 522 
sec. 16, 47 Stat. 725, 736. Under the original Bank Act, however, these 
reserves were in addition to the section 16 requirement that each Bank 
carry to ``a reserve account semiannually 20 per centum of its net 
earnings until said reserve account shall show a credit balance equal 
to 100 per centum of the paid-in capital of such [B]ank,'' and 
thereafter, that each Bank add to such reserve ``5 per centum of its 
net earnings. * * *'' Id. This was often referred to as the ``legal 
reserve'' requirement.
    FIRREA amended the Bank Act to delete the provision that the Banks 
carry a mandated percentage of their net earnings to a reserve, and 
substituted the current language that a Bank ``may carry to a reserve 
account from time-to-time such portion of its net earnings as may be 
determined by its board of directors.'' The language authorizing the 
Finance Board to require each Bank to establish additional reserves 
remained, although after FIRREA such reserves would be in addition to 
any that the Bank had voluntarily established.\20\
---------------------------------------------------------------------------

    \20\ FIRREA also changed section 16(a) of the Bank Act to allow 
after January 1, 1992, a Bank to pay dividends from ``previously 
retained earnings or current net earnings remaining after reductions 
for all reserves, charge-offs, purchases of capital certificates of 
the Finance Corporations, and payments relating to the Funding 
Corporation * * * have been provided for'' subject to certain 
additional exceptions. This change was meant to account for the 
termination of the legal reserve requirement and allow any remaining 
legal reserves that were held by the Banks to be used as a source of 
funds for dividends. As explained by the Finance Board when it 
adopted rules to implement this FIRREA change to the dividend 
provision:
    The * * * Banks' retained earnings are comprised of the legal 
reserve, the dividend stabilization reserve and undivided profits. 
Since the * * * Banks are prohibited from paying dividends from the 
legal reserve in section 16 of the Bank Act, [Finance Board rules] 
could not generally provide for the payment of dividends from 
retained earnings. Rather [they] specifically listed the two 
components of retained earnings from which there could be payment of 
dividends, namely the dividend stabilization reserve and undivided 
profits. Effective January 1, 1992, however, section 724 of [FIRREA] 
amends the Bank Act by eliminating the legal reserve in section 16 
of the Bank Act. * * * Thus, retained earnings shall only include 
the dividend stabilization reserve and undivided profits.
    Proposed Rule: Dividends Paid on Federal Home Loan Bank Stock, 
56 FR 59898, 59899 (Nov. 26, 1991).
---------------------------------------------------------------------------

    While FIRREA eliminated the mandatory legal reserve requirement, 
neither the wording of the FIRREA provisions nor available legislative 
history suggests that Congress intended to alter either the long 
standing accounting treatment or interpretations with regard to 
reserves required under section 16--namely that they were accounted for 
in retained earnings and were not valuation or similar reserves--or the 
Finance Board's authority under this section to require the Banks to 
hold additional reserves. The proposed retained earnings requirement 
comports with this definition of what is meant by reserves under 
section 16, and the scope of the authority provided the Finance Board 
under this section would be sufficient to support the Finance Board's 
adopting a retained earnings rule along the lines currently proposed.

III. Regulatory Flexibility Act

    The proposed rule would apply only to the Banks, which do not come 
within the meaning of small entities as defined in the Regulatory 
Flexibility Act (RFA). See 5 U.S.C. 601(6). Therefore, in accordance 
with section 605(b) of the RFA, 5 U.S.C. 605(b), the Finance Board 
hereby certifies that the proposed rule, if adopted as a final rule, 
would not have a significant economic effect on a substantial number of 
small entities.

IV. Paperwork Reduction Act

    The proposed rule does not contain any collections of information 
pursuant to the Paperwork Reduction Act of 1995. See 44 U.S.C. 3501 et 
seq. Therefore, the Finance Board has not submitted any information to 
the Office of Management and Budget for review.

List of Subjects

12 CFR Part 900

    Community development, Credit, Federal home loan banks, Housing,

[[Page 13315]]

Reporting and recordkeeping requirements.

12 CFR Part 917

    Community development, Credit, Federal home loan banks, Housing, 
Organizations and functions (Government agencies), Reporting and 
recordkeeping requirements.

12 CFR Part 925

    Credit, Federal home loan banks, Reporting and recordkeeping 
requirements.

12 CFR Part 930

    Capital, Credit, Federal home loan banks, Investments, Reporting 
and recordkeeping requirements.

12 CFR Part 931

    Capital, Credit, Federal home loan banks, Investments, Reporting 
and recordkeeping requirements.

12 CFR Part 934

    Capital, Credit, Federal home loan banks, Investments, Reporting 
and recordkeeping requirements.
    For the reasons stated in the preamble, the Finance Board proposes 
to amend 12 CFR, chapter IX, as follows:

PART 900--GENERAL DEFINITIONS APPLYING TO ALL FINANCE BOARD 
REGULATIONS

    1. The authority citation for part 900 continues to read as 
follows:

    Authority: 12 U.S.C. 1422b(a).

    2. Amend Sec.  900.2 by adding in alphabetical order, a defined 
term to read as follows:


Sec.  900.2  Terms relating to Bank operations, mission and 
supervision.

* * * * *
    Excess stock means that amount of a Bank's capital stock held by a 
member or other institution in excess of its minimum investment in 
capital stock required under the Bank's capital plan, the Act, or the 
Finance Board's regulations, as applicable.
* * * * *

PART 917--POWERS AND RESPONSIBILITIES OF BANK BOARDS OF DIRECTORS 
AND SENIOR MANAGEMENT

    3. The authority citation for part 917 continues to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1426, 1427, 
1432(a), 1436(a), and 1440.

    4. Revise Sec.  917.9 to read as follows:


Sec.  917.9  Dividends.

    (a) A Bank's board of directors may declare and pay a dividend only 
from previously retained earnings or current net earnings and only in 
accordance with any other applicable limitations on dividends set forth 
under the Act or this chapter. Dividends on such capital stock shall be 
computed without preference.
    (b) The requirement in paragraph (a) of this section that dividends 
shall be computed without preference shall cease to apply to any Bank 
that has established any dividend preferences for one or more classes 
or subclasses of its capital stock as part of its approved capital 
plan, as of the date on which the capital plan takes effect.
    (c) A Bank's board of directors may declare and pay a dividend only 
after the close of the quarter to which the dividend pertains and the 
Bank's earnings for that quarter have been calculated, and may not 
declare or pay a dividend based on projected or anticipated earnings.

PART 925--MEMBERS OF THE BANKS

    5. The authority citation for part 925 continues to read as 
follows:

    Authority: 12 U.S.C. 1422, 1422a, 1422b, 1423, 1424, 1426, 1430, 
and 1442.

    6. Revise Sec.  925.23 to read as follows:


Sec.  925.23  Prohibition on purchase of excess stock.

    A member, or an institution that has been approved for membership 
in a Bank, may not purchase capital stock from a Bank if that stock 
would be excess stock at the time of purchase.

PART 930--DEFINITIONS APPLYING TO RISK MANAGEMENT AND CAPITAL 
REGULATIONS

    7. The authority citation for part 930 is revised to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1436(a), 1440, 
1443, and 1446.

    8. Amend Sec.  930.1 by removing the definition of the term 
``excess stock'' and adding, in alphabetical order, the following 
defined terms to read as follows:


Sec.  930.1  Definitions.

* * * * *
    Current net earnings means the net income of a Bank for a calendar 
quarter calculated in accordance with GAAP after deducting the Bank's 
required contributions for that quarter to the Resolution Funding 
Corporation under sections 21A and 21B of the Act (12 U.S.C. 1441a and 
1441b) and to the Affordable Housing Program under section 10(j) of the 
Act (12 U.S.C. 1430(j)) and Sec.  951.2 of this chapter, but before 
declaring any dividend under section 16 of the Act (12 U.S.C. 1436).
* * * * *
    Retained Earnings Minimum or REM means the minimum amount of 
retained earnings a Bank is required to hold under Sec.  934.2 of this 
chapter.
* * * * *

PART 931--FEDERAL HOME LOAN BANK CAPITAL STOCK

    9. The authority citation for part 931 is revised to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1436(a), 1440, 
1443, and 1446.

    10. Revise Sec.  931.2(a) to read as follows:


Sec.  931.2  Issuance of capital stock.

    (a) In general. A Bank may issue either one or both classes of its 
capital stock (including subclasses), as authorized by Sec.  931.1, and 
shall not issue any other class of capital stock. A Bank shall issue 
its stock only to its members and only in book-entry form, and the Bank 
shall act as its own transfer agent. All capital stock shall be issued 
in accordance with the Bank's capital plan. A Bank may not sell capital 
stock to a member or to an institution that has been approved for 
membership in the Bank if that stock would be excess stock at time of 
the sale.
* * * * *
    11. Revise Sec.  931.4(b) to read as follows:


Sec.  931.4  Dividends.

* * * * *
    (b) Limitation on payment of dividends. In no event shall a Bank 
declare or pay any dividend on its capital stock if after doing so the 
Bank would fail to meet any of its minimum capital requirements, nor 
shall a Bank that is not in compliance with any of its minimum capital 
requirements declare or pay any dividend on its capital stock. A Bank 
also may not declare or pay a dividend that would violate any 
limitation on dividends set forth in part 934 of this chapter.
    12. Add part 934 to title 12, chapter IX, to read as follows:

PART 934--EXCESS STOCK LIMITS, MINIMUM RETAINED EARNINGS, AND 
DIVIDEND LIMITATIONS

Sec.
934.1 Limitation on excess stock and stock dividends.
934.2 Minimum level of retained earnings.
934.3 Dividend limitations if retained earnings are below the 
Retained Earnings Minimum.
934.4 Additional limitations on dividends.


[[Page 13316]]


    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), and 1436.


Sec.  934.1  Limitation on excess stock and stock dividends.

    (a) Excess Stock Limitation. The aggregate amount of a Bank's 
outstanding excess stock may not exceed one percent of the total assets 
of that Bank.
    (b) Prohibition on Stock Dividends. A Bank may not declare or pay a 
dividend in the form of additional shares of capital stock.
    (c) Violation of the Excess Stock Limitation. If the aggregate 
amount of a Bank's outstanding excess stock exceeds one percent of its 
total assets as of the close of the last business day of a quarter:
    (1) The Bank shall report such violation to the Finance Board; and
    (2) Within 60 calendar days of the close of that quarter, the Bank 
shall:
    (i) Develop an excess stock compliance plan acceptable to the 
Finance Board that addresses how the Bank will bring its outstanding 
amount of excess stock into compliance with the limitation, unless the 
Bank is already operating under such a plan; or
    (ii) Certify in writing to the Finance Board that it has corrected 
the violation and is in compliance with the excess stock limitation.


Sec.  934.2  Minimum level of retained earnings.

    (a) General. Each Bank is required to maintain a level of retained 
earnings at least equal to the Bank's Retained Earnings Minimum (REM). 
If a Bank's retained earnings, as of the close of the quarter and after 
deducting the amount of any intended dividend for that quarter, would 
be below its REM, the Bank must comply with the applicable dividend 
limitation set forth in Sec.  934.3 of this part.
    (b) Calculation of the REM. Each Bank's REM will equal $50 million 
plus 1 percent of the Bank's non-advance assets. Each Bank shall 
calculate its REM each calendar quarter. For purposes of the REM 
calculation, a Bank's non-advance assets shall equal the daily average 
of the Bank's total assets less the daily average of its advances, for 
the quarter immediately preceding the date of the calculation.
    (c) Adjustment to the REM. For reasons of safety and soundness, the 
Finance Board may establish a REM for a Bank that is higher than the 
amount calculated under paragraph (b) of this section.


Sec.  934.3  Dividend limitations if retained earnings are below the 
Retained Earnings Minimum.

    (a) Initial limitation. Until a Bank initially reaches or exceeds 
its REM, the Bank may not declare or pay a dividend that exceeds 50 
percent of its current net earnings without the prior approval of the 
Finance Board, if, as of the close of the quarter and after deducting 
the amount of the intended dividend for that quarter, the Bank's 
retained earnings would be below its REM.
    (b) Limitation thereafter. After a Bank first complies with its 
REM, the Bank may not declare or pay a dividend without the prior 
approval of the Finance Board, if, as of the close of the quarter and 
after deducting the amount of the intended dividend for that quarter, 
the Bank's retained earnings would be below its REM.


Sec.  934.4  Additional limitations on dividends.

    (a) Timing of declaration. A Bank may declare and pay a dividend 
only after the close of the quarter to which the dividend pertains and 
the Bank's earnings for that quarter have been calculated, and may not 
declare or pay a dividend based on projected or anticipated earnings.
    (b) Other limitations. In addition to any applicable limitations 
set forth in the Act or elsewhere in this chapter, at no time may a 
Bank declare or pay a dividend if the par value of the Bank's stock is 
impaired or is projected to become impaired after paying such dividend.

    Dated: March 8, 2006.

    By the Board of Directors of the Federal Housing Finance Board.
Ronald A. Rosenfeld,
Chairman.
[FR Doc. E6-3689 Filed 3-14-06; 8:45 am]
BILLING CODE 6725-01-P